What Does ERC Mean? The Employee Retention Credit Explained

The Employee Retention Credit (ERC) is a refundable tax credit designed to support businesses that retained employees during the economic disruptions caused by the COVID-19 pandemic. Introduced as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March 2020, the ERC provided financial relief to eligible employers.

What the Employee Retention Credit Is

The Employee Retention Credit encouraged businesses to maintain their workforce during the economic challenges of the COVID-19 pandemic. It was established as a refundable payroll tax credit, meaning qualifying businesses could receive a refund even if the credit amount exceeded their payroll tax liability. This provided direct financial assistance to employers, helping them cover wage costs and avoid layoffs.

This credit was available for qualified wages paid between March 13, 2020, and September 30, 2021, for most employers. Recovery startup businesses could claim the credit for wages paid through December 31, 2021. Businesses could qualify in one of two ways: by experiencing a significant decline in gross receipts or by having their operations fully or partially suspended due to a government order related to COVID-19.

Determining Eligibility

Eligibility for the Employee Retention Credit involved meeting specific criteria related to a business’s operations or financial performance during the pandemic. The two paths to qualification were demonstrating a significant decline in gross receipts or proving a full or partial suspension of operations due to governmental orders. These criteria varied between 2020 and 2021.

For the significant decline in gross receipts test, businesses compared their quarterly gross receipts to those from 2019. In 2020, a business qualified if its gross receipts for a calendar quarter were less than 50% of its gross receipts for the same calendar quarter in 2019. For 2021, the threshold was reduced; a business qualified if its gross receipts for a calendar quarter were less than 80% of its gross receipts for the same quarter in 2019. For 2021, businesses could elect to use the immediately preceding calendar quarter for comparison to the corresponding 2019 quarter to determine eligibility.

Alternatively, businesses could qualify if their operations were fully or partially suspended due to a government order limiting commerce, travel, or group meetings because of COVID-19. A full suspension occurred if a business was entirely shut down by such an order. A partial suspension could apply if a portion of operations was impacted by an order, even if the business remained open. For instance, if a restaurant’s indoor dining was prohibited by a government mandate, but takeout service continued, this could constitute a partial suspension if the suspended portion represented at least 10% of gross receipts or employee hours.

The definition of “qualified wages” also varied by year and employer size. For 2020, qualified wages included up to $10,000 per employee for the year, with a credit of 50% of those wages, capping at $5,000 per employee. For 2021, the credit increased to 70% of qualified wages, up to $10,000 per employee per quarter, allowing for a maximum of $7,000 per employee per quarter for the first three quarters. Both cash wages and qualified health plan expenses were included in qualified wages.

The size of the employer, based on average full-time employees in 2019, affected which wages counted. For employers with 100 or fewer full-time employees in 2019, all wages paid to employees were qualified, regardless of whether employees were working. For employers with more than 100 full-time employees in 2019, only wages paid to employees for not providing services qualified. For 2021, the threshold for large employers increased to more than 500 average full-time employees, meaning businesses with 500 or fewer employees could count all wages.

Initially, businesses that received Paycheck Protection Program (PPP) loans could not claim the ERC. However, the Consolidated Appropriations Act of 2021 retroactively changed this, allowing businesses to claim both, provided the same wages were not used for both programs. Recovery startup businesses could claim the ERC for the third and fourth quarters of 2021, even without meeting the gross receipts or suspension tests, if established after February 15, 2020, and having average annual gross receipts not exceeding $1 million.

How to Claim the Credit

Claiming the Employee Retention Credit involved a specific process, primarily through the submission of amended employment tax returns. Businesses generally filed Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund, to retroactively claim the credit.

This form allows employers to correct errors or make adjustments to previously filed Forms 941, Employer’s Quarterly Federal Tax Return. When completing Form 941-X, businesses provided detailed information, including the original amounts reported on Form 941 and the corrected amounts reflecting the qualified wages and the calculated ERC.

The completed Form 941-X, along with supporting documentation, was mailed to the Internal Revenue Service (IRS). The process for receiving the credit involved reducing future payroll tax deposits or receiving a refund check from the U.S. Treasury. Processing times for amended returns and refunds varied, typically ranging from several weeks to several months.

When claiming the ERC, businesses must reduce their wage expense deduction on their income tax returns for the amount of the credit. This adjustment is necessary because the ERC effectively reduces the cost of wages, and businesses cannot deduct expenses that are reimbursed. An amendment to the business’s income tax return, such as Form 1120 for corporations or Schedule C for sole proprietors, might also be required.

Post-Claim Considerations

After claiming the Employee Retention Credit, businesses face ongoing considerations, particularly regarding record-keeping and potential IRS scrutiny. Businesses should retain documentation supporting their eligibility, including payroll records, calculations of qualified wages, evidence of government orders (if applicable), and gross receipts calculations. These records should be kept for at least three years from the date the amended return was filed, though the IRS has an extended five-year statute of limitations for certain ERC claims.

The IRS has increased its focus on ERC claims due to a high volume of improper or fraudulent filings. Businesses that claimed the credit may face IRS audits or compliance checks. During such reviews, the IRS examines documentation to verify eligibility and the accuracy of the claimed credit amount. If the IRS determines a claim was incorrect, businesses may be required to repay the credit, potentially with penalties and interest.

The IRS announced a moratorium on processing new ERC claims as of September 14, 2023. This temporary halt was implemented to combat fraud and ensure the integrity of the program. For businesses that submitted claims before the moratorium, processing continues with enhanced review procedures, potentially extending the typical processing time.

The IRS has also introduced a Voluntary Withdrawal Program, which allows businesses to withdraw claims if they realize they were ineligible or were pressured into making an incorrect claim by third-party promoters. This program offers a pathway for businesses to avoid future penalties and interest. The IRS has also issued warnings about third-party promoters who aggressively market ERC services, and advises businesses to consult tax professionals for accurate guidance.